November 3, 2013

Puerto Rico’s Bond Woes: What Went Wrong?

The island was flying high on the Fed’s quantitative easing; now the possible pullback has had an outsize, and devastating, impact

Federal Reserve building. (Photo: AP) Federal Reserve building. (Photo: AP)

Puerto Rico no está bien. The Sharks and the Jets may be snapping and circling, but it’s the muni space that’s getting beat up.

The recent implosion of Puerto Rico municipal bonds is part of a larger pattern with certain U.S territory issues, but the tropical island is by far the highest profile to date. CNN recently asked if Puerto Rico was the next Detroit, or possibly Greece. The network is far from alone in its worry. The price of Puerto Rico's debt plummeted nearly 40% in just a few months this past summer, it notes. That pushed interest rates on Puerto Rico bonds up to nearly 10% from 5%.

Why did it happen?

Puerto Rico’s already stagnant economy was further damaged by the Federal Reserve’s tapering expectations and Detroit’s bankruptcy. Investors naturally looked to the next trouble spot, and the island was first on the list. Starting with an August cover story by Barron’s that alerted investors to the problem, the selloff that followed perpetuated itself, and the rest, as they say, is recent history.

It wasn’t always this way. Along with Guam and the U.S. Virgin Islands, it performed exceeding well in recent years, thanks in large part to quantitative easing measures undertaken by the Federal Reserve to help stimulate the economy. Yet as high as Puerto Rico was once able to fly as a result of the boost, it now finds itself just as low with the government program coming to an end.

The impact is far-reaching. Reuters, citing Lipper data, reports that U.S. municipal bond funds with at least 5% exposure to Puerto Rican debt have experienced an $8.3 billion decline in net assets this year.

The 16.3% decline from $50.6 billion at the end of 2012 comes as U.S. and state regulators investigate whether the funds adequately disclosed their exposure to Puerto Rico, the news service adds. Muni bond funds with less than 5% exposure have declined only 10% to $476.5 billion.

The local economy, mutual funds and regular investors may be hurting as a result of the turmoil, but not everyone is unhappy. Hedge funds, distressed asset investors and regular bargain hunters are beginning to enter as others exit. The reason, according to MarketWatch, is that unlike in Detroit, Chapter 9 of the bankruptcy code doesn’t permit Puerto Rico to file for bankruptcy if its financial situation worsens, “which means that a failure of the territory to make good on its bonds wouldn’t lead to an organized restructuring process.”

More likely, it notes, it would lead to mayhem, with no system for the debtor and its creditors to negotiate a solution. Further, Puerto Rican debt makes up a substantial portion of the municipal bond market, so a default could create systemic ripples. For these reasons, the federal government would almost certainly step in with a bailout, something on which contrarian investors are now betting.

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Check out Cash In on Washington Dysfunction, Friedman Urges Investors on ThinkAdvisor.

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